The nation faces a nasty dual deficit problem: a painful jobs deficit in the near term and an unsustainable budget deficit over the medium and long term. This month, the Senate will be debating an issue with significant implications for both â?? what to do about the Bush-era tax cuts scheduled to expire at the end of the year.
In the face of the dueling deficits, the best approach is a compromise: extend the tax cuts for two years and then end them altogether. Ideally only the middle-class tax cuts would be continued for now. Getting a deal in Congress, though, may require keeping the high-income tax cuts, too. And that would still be worth it.
Why does this combination make sense? The answer is that over the medium term, the tax cuts are simply not affordable. Yet no one wants to make an already stagnating jobs market worse over the next year or two, which is exactly what would happen if the cuts expire as planned.
Higher taxes now would crimp consumer spending, further depressing the already inadequate demand for what firms are capable of producing at full tilt. And since financial markets donâ??t seem at the moment to view the budget deficit as a problem â?? take a look at the remarkably low 10-year Treasury bond yield â?? there is little reason not to extend the tax cuts temporarily.
A benign bond market, however, is a luxury we wonâ??t enjoy forever if we fail to tackle our long-term fiscal problem. Whatâ??s more, losing the confidence of the bond market could prove painful, since it is widely known that our fiscal trajectory is unsustainable and market sentiment may therefore shift quickly and unpredictably. In any case, as the economy recovers, the dominant problem will move from depressed demand to excessive budget deficits.
Despite a dire fiscal outlook, many progressives want to make the tax cuts permanent for all but the very highest earners. Many conservatives are even worse: theyâ??d make the tax cuts permanent for the likes of Warren Buffett, even though heâ??d prefer they didnâ??t. Making all the tax cuts permanent would expand the deficit by more than $3 trillion over the next decade.
Both approaches lock us into a budget scenario out of which there are few politically plausible routes of escape. Although hardly anyone wants to admit it, weâ??re not going to solve our budget problem over the next decade unless revenue is part of the equation.
Letâ??s look at the facts. The projected deficit for 2015 is 4 percent to 5 percent of G.D.P., depending on whose assumptions you use. A sustainable level is more like 3 percent or lower. So we need deficit reduction of 1 percent to 2 percent of G.D.P., or about $200 billion to $400 billion a year by 2015. These figures are uncertain, but theyâ??re the best we have (and they may well turn out to be too optimistic).
How much savings is plausible on the spending side? Medicare, Medicaid and Social Security will account for almost half of spending by 2015. Even if we reform Social Security, which we should, any plausible plan would phase in benefit changes to avoid harming current beneficiaries â?? and so would generate little savings over the next five years. The health reform act included substantial savings in Medicare and Medicaid, so there arenâ??t further big reductions available there in our time frame.
The other half of the budget is mostly net interest (which is not negotiable unless we renege on our debt) and discretionary spending. Discretionary spending is split roughly equally between defense and non-defense spending. The defense component already assumes a phase-down in both Iraq and Afghanistan; saving an additional 5 percent of the Pentagonâ??s base budget would be a substantial accomplishment and would yield about 0.2 percent of G.D.P. Cutting 5 percent out of non-defense discretionary spending, a stretch politically, would save about as much.
It would be tough, then, to squeeze more than a half percent of G.D.P. from spending by 2015. Additional revenue â?? in the range of 0.5 to 1.5 percent of the economy â?? will therefore be necessary to reduce the deficit to sustainable levels.
How would we do this?
Peter Orszag, the director of the White House Office of Management and Budget from 2009 to 2010 and a distinguished visiting fellow at the Council on Foreign Relations, is a contributing columnist for The Times. He will also be writing at nytimes.com/opinionator.
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